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Bernanke And The Shibboleths

November 6, 2010 11:42 amNovember 6, 2010 11:42 am

Everyone hates quantitative easing. The inflationistas believe that it’s the end of Western civilization (but as a correspondent points out, we
want them to believe that; similar beliefs about the end of the gold standard helped recovery in the 1930s); meanwhile, the rest of the world is furious at the Fed’s actions.

Clearly, Bernanke must be doing something right. As Greg Ip says, all the objections currently being offered to QE would apply equally well to conventional monetary policy — and given high US unemployment and sagging inflation, how can you argue that monetary expansion is unjustified?

But what we’re seeing worldwide right now is an inability to think clearly about economics. In particular, the unconventional nature of our situation is making it clear how many people rely not on any model of
how the economy works but rather on what the late Paul Samuelson called shibboleths — by which he meant slogans that take the place of hard thinking.

The basic situation of the world economy is simple: we have an excess of desired saving over desired investment, even at a zero interest rate. It looks like this, where the savings and investment schedules are what
those schedules would be if we were at full employment:

How did this happen? The answer, mainly, is that over-borrowing in the past has left large parts of the world credit-constrained, forced to deleverage by cutting spending; and even a zero interest rate isn’t
enough to persuade the unconstrained players to increase spending by enough to offset these cuts.

Yet interest rates can’t go below zero; which poses a problem. For the world as a whole, savings must equal investment, or, equivalently, spending must equal income. So this incipient excess of savings leads
to a depressed world economy, in which income falls to match the amount people are able/willing to spend.

So what can policy do?

1. It can try to achieve negative real interest rates by creating expectations of inflation. That’s actually the more or less free-market solution. Many years ago I tried to explain this by considering a hypothetical world of perfectly flexible prices and a fixed money supply. How would such a world deal with the situation shown above? The answer is, prices would plunge far
enough that people would expect them to rise again in the future, generating the expected inflation we need. Since prices aren’t perfectly flexible, and anyway the existence of nominal debt makes massive
deflation a really bad idea, the preferred alternative is simply to create expectations of inflation looking forward.

2. Alternatively, governments can step in and spend while the private sector won’t.

3. Finally, central banks can try to circumvent the zero lower bound by buying long-term debt. The point here is that we only have zero rates at the short end, and it’s possible, though not certain, that you
can get at least some traction by buying those longer-term bonds.

But now that we’re in this situation, VSPs around the world are objecting to all of these possible actions. Inflation targets are horrible because we must have price stability. Fiscal policy is unacceptable because
we must have balanced budgets. QE is outrageous because that’s not what central banks are supposed to do.

Notice that in each case the objection is based on a shibboleth. Price stability is treated as an absolute virtue, without any model to explain why. The same with budget balance. And those who are horrified at the idea
of expansionary monetary policy have been inventing concepts on the fly to justify their position.

The simple fact is that we have a global excess supply of savings, which is doing terrible things to workers. The reasonable thing is to do something about it; it’s deeply unreasonable, and deeply irresponsible,
to invent reasons not to act because you’re clinging to simplistic slogans.